Firms and Transactions Costs

Last week, I wrote a few inadequate words about one of this year's Nobel laureates in economics, Elinor Ostrom.

Today, I will say a few about the other winner, Oliver Williamson. His work, as it turns out, cuts close to the core subject of this blog, the struggle for power in the corporate suites.

Williamson throughout his career has concerned himself with what is called the "theory of the firm." Crudely put, this is an effort to answer the question: why are some activities undertaken within a firm, and others are contracted for outside of its boundaries, in the market?

Suppose some firm (a corporation in the business of manufacturing widgts) owns the office building where it is headquartered. It could contract with another firm for janitorial services, or it could hire its own on-payroll janitors. In the one case, the maintenance functions of that building would be a market transaction, in the other case they would be a matter decisions made by the in-firm hierarchy. Obviously some firms do the one and other firms do the other. What determines which is which?

Williamson picked up on earlier work answering this sort of question by Ronald Coase (who received the Nobel himself in 1991). The Coase-Williamson answer is that there are costs as well as benefits in contracting a function out. There is the cost of searching among the possible providers, and checking among the competing maintenance servicers to see who has the better price, who has the fewer customer complaints and so forth. All of that requires time and expense. There are also costs asociated with striking a bargain with the outsiders, and costs associated with policing and enforcing compliance with the deal struck.

On the other hand, taking janitors onto the payroll, and creating an inhouse maintenance department for them, has costs, too. Just for example: there are various legal distinctions between "big business" and "small business" designed to favor the latter, and many of those distinctions turn on the number of employees. So creating such a department may push a firm past one or more thresholds whereby it will be treated more rigorously by the law of its jurisdiction as a "big business."

Separately, though, there is possibility that the in-house operation will be lazier than an outsourcing company. For that matter, so might a formally outsourced maintenance company with a sufficiently secure long-term contract. In either case, they won't be as "hungry" in a competitive sense as the widget making corporation might want them to be.

Williamson's point was the apparently simple one that both hierarchical and contractual means of solving a particular problem have costs, and that the relative size of those costs will differ from case to case. Businesses will tend to the approach that economizes on their costs. Or, as the press release put out by the Prize Committee says, Williamson say markets and firms as "represent[ing]. alternative governance structures which differ in their approaches to resolving conflicts of interest."

That is simple enough to say, but more complicated to work out in in sufficiently impressive detail to make a scholarly impression. Williamson did so, and contributed to the development of scholarly rigor in discussions of a range of issues in corporate governance.

A Game Theorist is Due?

The official Nobel Prizes have all been bestowed. What remains is the unofficial Nobel.

What is loosely termed the Nobel Prize in Economics is actually the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. It was not one of the prizes for which the old dynamiter provided in his will, althouh it has successfully ridden along on their coattails and established for itself an analogous eminence.

Regardless: tomorrow we will know the name of this year's winner(s) of this final 'Nobel.'

If we list the winners of the last five years, we can see that the committee has oscillated back and forth between general game-theoretic approaches to social science (inclusive of course of economics) on the one hand, and hardcore economics as an autonomous field on the other. This oscillation goes back to the Nash/Selten/Harsanyi award of 1995, immortalized by Hollywood but we'll stick to the more recent swerves.

2004 Finn E. Kydland and Edward C. Prescott. Kydland teaches at the University of California, Santa Barbara, Prescott at Arizona State. They won for work on the business cycle.

2005 Robert J. Aumann and Thomas C. Schelling. Aumann is at Hebrew University of Jerusalem, in Israel. Schelling is retired, but is most closely associated with Harvard University. They won for game theory. This prize was interpreted by some as evidence the economics Award was morphing into a more general social-sciences award.

2006 Edmund S. Phelps. This was more hadcore economics, though. Phelps won for work on "intertemporal tradeoffs in macroeconomic policy." Specifically, he postulated a "natural rate of unemployment." The simple but depressing idea that government policies designed to push unemployment below this rate will have adverse consequences later sounds a little better if it is called an intertemporal trade-off, doesn't it?

2007 Leonid Hurwicz, Eric S. Maskin, Roger B. Myerson. Hurwicz is affiliated with the University of Minesota; Maskin with Princeton; Myerson with the University of Chicago. This was again an award for game theory, although the prize committee referred to it as "mechanism design theory."

2008 Paul Krugman. Economics in a strict sense again.

So I'm thinking 2009 will be a year for social science and game theory once again.

News Sense

Okay, my news sense isn't always infallible. Sometimes I think I'm on to something big, and it fizzles.

Such is the case with the Microsoft annual meeting held yesterday. There were two shareholder resolutions, and I discussed them in Monday's entry. There's really nothing to say about yesterday's meeting, though, except that all members of the board of directors were re-elected and, as the company management had recommended, both resolutions went down to defeat.

Sometimes I sense a story in the world of academic in-fighting, too. This can work out, but might not.

On Friday, I wrote a story for HedgeWorld (my dayjob) about such an academic dispute, in the world of quantitative finance. I over-state the degree to which I understand such things when I write of them, but hey -- I did take a course in calculus once.

The underlying conflict is between Nassim Taleb and the remaining authors of the famous/infamous Black-Scholes articles concerning the pricing of stock options. Fischer Black, alas, is deceased. The other namesake of the formula, Myron Scholes, is very much alive, as is Robert Merton.

Both Scholes and Merton won a Nobel Prize for their work on Black-Scholes, sometimes more generously called Black-Scholes-Merton. But Nassin Taleb, the author of a couple of widely-read books on risk and its management, says that the formula in the form they offered it, doesn't work very well. Options traders don't use it. Further, he says, it wasn't original enough with them to have their names on it, so it should be called Bachelier-Thorp if referenced any more at al.

I thought this was a big story. I did the usual consacientious reporterly work, wrote up various views of Black-Scholes on the one hand and Taleb's challenge on the other, and my editors posted the result at HedgeWorld.

One of the responses I've had since then has been to the effect that it isn't really newsworthy. Some bitter second-rate fellow envies the Nobel Prize winners and is trying to tear them down: why is that a story? one reader asked me.

All I could say is that arguing over what is newsworthy and what isn't is a mugs game, and I declined to get involved in it. She might be right, and Taleb might simply disappear.

Or, this might be the start of something big, and my readers would have heard of it early on. Damned if I know which is the case.